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standard costing variance analysis
relevant to CAT Scheme Paper 7 and Professional Scheme Paper 1.2
Standard costing variance analysis questions are a common feature of CAT Paper 7 exams. This is the first in a series of three articles which consider the calculation of variances, the causes of variances, and how managers should react to variances. This article considers variance calculations and highlights some lessons that should be learnt from common mistakes made in the exam room. The second article starts on page 58. The term ‘standard’ refers to predetermined, estimated unit costs and revenues. A standard cost is often described as a ‘budget for an individual unit of production’. The primary use of standards is in the calculation of variances. Variances are used in the control of costs and revenues, and to stimulate improved performance. They are calculated by comparing actual costs and revenues with standard costs and revenues. EXAMPLE 1 McDermott plc is a manufacturer of beds. It uses a system of standard absorption costing and variances to monitor performance of managers and departments. A standard cost card for one of its models, the Dreamer, is given below. £ per unit Selling price Direct material: Wood: 12m @ £1.50 per m Fabric: 6m2 @ £2.00 per m2 Direct labour: 4 hours @ £6.00 per hour Variable overhead: 4 hours @ £15.00 Fixed overhead: 4 hours @ £10.00 Profit Budgeted production and sales are 1,000 Dreamers per month. Actual results for the manufacture and sale of Dreamers for the most recent month are as follows: Sales: 1,200 units @ £240 each Production: 1,300 units Wood 16,000m @ £1.40 per m Fabric 7,800m2 @ £2.10 per m2 £ per unit 250.00 Direct labour: 5,000 hours @ £7.00 per hour Variable overhead: 5,000 hours @ £15.10 per hour Fixed overhead: £54,600. There was no opening stock. TERMINOLOGY Throughout this article the term ‘adverse variance’ (Adv) describes a situation where actual results are worse than standard and have a detrimental effect on profit (costs are higher or revenues lower), ‘favourable’ (Fav) describes the opposite situation. Many candidates omit these signs and thus lose half of the marks available for calculation. In practice, and in the exam, variances are little use without a sign. Some candidates use negative signs or brackets for adverse variances, and no signs for favourable variances. This causes marking problems, because it becomes difficult to tell the difference between a favourable variance and one without a sign. Lesson 1 Always clearly label variances as either adverse or favourable. These labels will represent 50% of the marks available for variance calculations. VARIABLE COST VARIANCES The direct labour variance is usually the simplest variance to calculate. Actual direct labour cost was £35,000 (5,000 hours x £7.00). This needs to be compared with the standard cost. A very common error in candidates’ calculations is to make the following comparison: Actual hours x actual rate = 5,000 hours x £7.00 =
18.00 12.00 24.00 60.00 40.00 154.00 96.00
£35,000 >£11,000 Adv labour variance
Budgeted hours x standard rate = 1,000 units x 4 hours x £6.00 = £24,000 This is not a sensible comparison. Actual costs relate to producing 1,300 units. Budgeted figures relate to producing 1,000 units. It is important to compare like with like. If labour is a variable cost then we would expect the extra 300 units to require extra labour hours. A more sensible, and correct, calculation is to compare the actual labour cost with the flexed budget labour cost of producing 1,300 units, as follows: May 2006 student accountant 53
300 units x 4 hours x £6.standard rate per hour) x actual hours = labour rate variance = (£6. In the case of McDermott.300 units Volume (units) candidates using the formula approach make far more errors than those using a tabular approach. I find that 54 student accountant May 2006 technical Actual fixed overhead £54. in my experience of marking.00 = £35. an efficiency variance. Lesson 4 If you can calculate one set of variable cost variances. or possibly both.800 adverse has two causes.£7.000 Adv rate variance Standard usage for actual production x standard rate Try this approach for yourself for McDermott’s other variable costs.000 £ Overhead absorbed at £40 per unit Volume variance Expenditure variance Budgeted volume 1. you should be able to calculate them all.00 = Actual hours x standard rate = 5. TABULAR OR FORMULA APPROACH? Many textbooks present the above calculation in a ‘formula’ format rather than the tabular layout adopted above.000 Budgeted fixed overhead £40.00 .00 = £31. and would attract full marks in the exam.600 Absorbed fixed overhead £52. Answers are given at the end of this article.800 adverse has two potential causes – either the firm has paid a different hourly rate to standard. FIXED OVERHEAD VARIANCES Most candidates have little difficulty in calculating the fixed overhead expenditure variance. probably quicker to use.600 >£14.000 units x 4 hours x £10.000 hours rather than the flexed budget 5.300 units x 4 hours).00 = £30.000 hours x £7.200 Lesson 2 It is important when calculating variable cost variances that figures are based on flexed budget figures.000 >£3.00) x 5. not original budgeted figures. Second. Lesson 3 Candidates using the tabular approach generally appear to make fewer errors in variance calculations.FIGURE 1: THE FIXED OVERHEAD VOLUME VARIANCE Actual hours x actual rate = 5. THE OTHER VARIABLE COST VARIANCES In their simplest form. The total labour variance of £3. First.000 >£5.000 hours x £6.000 hours = £5. we do not need to flex the budget to obtain a sensible like-with-like comparison.300 units x 4 hours x £6. caused by paying more per hour than standard. all the other variable cost variances (direct material and variable overhead) follow the same pattern of calculation as direct labour. If we insert a third line into the analysis we can separate out these two causes.000 .000 Adv. the labour rate variance calculation is often presented as follows: (actual rate per hour .300 units in 5.00 = £31. caused by making 1.000 >£1. or it has used a different amount of hours per unit to standard.00 = £40.200 We can now see that the total variance of £3.200 hours (1.200 Fav efficiency variance Standard hours for actual production x standard rate = 1. the calculation of the fixed overhead expenditure variance is: Actual fixed overhead expenditure £54. This layout is perfectly valid. This is a simple variance to calculate because.800 Adv labour variance Standard hours for actual production x standard rate = 1. a rate (or more generally expenditure) variance. However.600 Adverse fixed overhead expenditure variance Budgeted fixed overhead expenditure = 1.000 hours x £7.000 units Actual volume 1. The calculation for all variable cost variances can be generally laid out as: Actual usage x actual rate >Expenditure variance Actual usage x standard rate >Efficiency variance £35. Actual hours x actual rate = 5. as we are dealing with a fixed cost. For example.
This is referred to as a favourable capacity variance.000 units x £96. The key to its correct calculation is to appreciate that it is concerned with the under or over absorption of overhead.000 Efficiency £52. leading to an adverse variance of £14. and hence the sales volume variance is evaluated at the standard profit margin. if the firm operates at the budgeted production level of 1.600.00 Actual sales units @ standard profit margin 1.000 hours are worked (1.000 Fav >£2.300 units. This standard fixed overhead absorption rate is designed to absorb budgeted fixed overhead at the budgeted production level. SALES VARIANCES Sales variances have two causes – failing to sell the budgeted quantity (the volume variance) and failing to sell at the budgeted price (the price variance). as the firm has operated at above its budgeted capacity and has therefore over absorbed overhead. A common error is to extend the difference at standard price per unit.200 hours Quite simply. This is incorrect. the firm has actually produced 1.00 = Actual hours @ standard rate per hour 5.00 £96.000 >£14.000 Efficiency variance Capacity variance Budgeted fixed overhead £40.300 units actually produced represent 5.000 Fixed overheads absorbed at £10 per hour FIGURE 2: TWO CAUSES OF VOLUME VARIANCE Budgeted hours = 1. because although a decrease in sales units would lead to a loss in sales revenue.200 units x £96. at the same time it also leads to a reduction in cost.000 units x 4 hours x £10.000 units x 4 hours per unit).technical £ Actual fixed overhead £54. This can be done when fixed overheads are absorbed on the basis of labour hours. and extending the difference at the standard profit margin. finished units are valued at standard cost with the fixed cost element in this case being £52.300 units x 4 hours x £10.000 hours. In a standard costing system. and is referred to as an efficiency variance.000 hours = 4. The amount of over absorbed overhead will have to be credited to the profit and loss account in the calculation of actual profit.200 Lesson 6 Sales volume variances should be based on standard profit margin not standard price.300 units x 4 hours = 5.000 hours Volume hours Standard hours for actual production = 1. £40. The calculation of the fixed overhead variances can be summarised as follows: Actual overhead = Budgeted overhead 1. over absorption would be credited to profit and hence is recorded as a favourable variance. Hence.600 on fixed overhead when the budget allowance was £40. In this case.000 (1. leading to an over absorption of £10.000 (1.000 >£19. The diagonal line leading from the origin shows overhead being absorbed at £40 per unit. This variance has been caused by using less labour than standard to make 1.000 Capacity £50.000 of overhead (the budgeted amount) will be absorbed.000. McDermott actually works 5.000 as compared to budget. and hence absorbed £52.300 units. the diagonal line through the origin represents fixed overheads being absorbed at a standard fixed overhead absorption rate of £10 per labour hour. Again. resulting in an over absorption of overhead as compared to budget.000 hours x £10. It is the net of these two figures that must be considered. May 2006 student accountant 55 .300 units x 4 hours x £10 per hour). Figure 2 illustrates this analysis. the fixed overhead volume variance causes candidates more difficulty than any other.00 = £54.300 units x £40 per unit) of overhead.600 Adv >£10.000 Actual hours = units x 4 hours per unit 5. The volume variance is calculated by comparing budgeted sales units with actual sales units. then budgeted overhead of £40.200 standard hours of work (1.000. McDermott has spent £54.000 units. In this example. This time. The 1. Figure 1 demonstrates how the variance occurs. This leads to a further over absorption of £2. If the budgeted 4.600 Absorbed at standard hours £52. It is possible to break the volume variance down into its two causes – capacity and efficiency.000 Fav Note that the fixed overhead volume variance can be obtained by summing the capacity and efficiency variance.200 Fav £115.300 units x 4 hours per unit). In contrast to the expenditure variance.600 Expenditure £40. and so it is described as a favourable variance.000 Absorbed at actual hours £50.000 will be absorbed.00 = Standard overhead for actual production 1. Budgeted sales units @ standard profit margin 1. as demonstrated below. Lesson 5 The fixed overhead volume variance (and its subdivision into the capacity and efficiency variance) relate to under or over absorption of overhead as compared to budget.
in the case of McDermott.300 units x 12m x £1.000m.000 >£12.000 Adv rate variance IDLE TIME VARIANCES Sometimes. but is unlikely to have control over hours lost due to machine breakdowns. The idle time variance will usually be considered as non-controllable.000 >£5. If. In these circumstances.000m and actual usage 16. The labour variances would then become: £25.000 Actual hours paid at actual rate 5.000m.800 >£2. the basis of the calculation of the material price variance may change.50 = Lesson 7 When materials purchases are different to raw material usage.000 hours paid for only 4. then stocks would have risen by 2.200 units x £250 MATERIAL STOCKS In a situation where the level of material purchases is different to material usage.000 hours x £7.000 Adv £300. Assume.50 = Actual usage at standard cost 16.000 >£1.000m x £1.40 = Actual purchases at standard cost 18. and stocks are valued at standard cost. hours worked by labour may be different to hours paid. This could be due to shortages of materials.000 hours x £6.800 Fav £27.000m x £1.The sales price variance evaluates the effect of selling at a non-standard price. rather than hours paid. The remaining hours were idle due to a machine breakdown.00 = £30.400 May 2006 . The variance calculation would be as follows: Actual purchases at actual cost 18.200 Basing the efficiency variance on hours worked supports responsibility accounting.50 = Standard usage at standard cost 1.200 Adv idle time variance Actual hours worked at standard rate 4. the labour efficiency variance should be based on hours worked. some of the calculations change. If material stocks are valued at standard cost then the price variance will be based on material purchased.00 = £35.000m x £1. machine breakdown.000 Actual hours paid at standard rate 5. that of the 5. STANDARD MARGINAL COSTING The above analysis is based on an absorption costing system.200 Price >£1. £24. in the case of McDermott.800 hours x £6. Under a marginal costing system. It is calculated by comparing actual and standard selling prices and extending the difference at standard price: Actual sales @ actual price 1. A standard marginal cost card for McDermott is given in Example 2. the raw material price variance should be based on units purchased.300 units x 4 hours x £6.00 = £31. The production manager will have control over the number of labour hours worked on production. not when it is idle.400 Fav efficiency variance Standard hours for actual production at standard rate 1. actual wood purchases had been 18. or stoppages in other parts of the business. It is important to note that other variances based on labour hours (variable and fixed overheads) should also be based on hours worked.200 units x £240 Actual sales @ standard price 1. The logic here is that overheads are incurred when labour is working.000 Usage >£600 Adv £23.00 = £28. 56 student accountant technical £288.800 were worked. Lesson 8 Labour efficiency variances (and overhead variances as appropriate) should be based on hours worked rather than hours paid.
400 Price >£1.50 per metre Fabric 6 metres2 @ £2. The second change is that the sales volume variance is now based upon contribution per unit rather than profit per unit.50 = Standard usage at standard cost 1.600 Usage >£0 £15.00 114.000 Fav £78. Marking schemes usually give one mark for the correct variance number.200 Lesson 10 In a marginal costing system.00 CONCLUSION Standard costing variance calculations sometimes appear daunting.200 units x £136 = £22.10 = Actual usage at standard cost 7.600 £136.000 Efficiency >£3.000 >£27. not profit per unit. calculated in exactly the same way as in absorption costing. The calculation is as follows: Budgeted sales units @ standard contribution margin 1.00 60.50 = Fabric Actual usage at actual cost 7.000 May 2006 student accountant 57 .00 per hour Variable overhead: 4 hours @ £15. Candidates need to work on past exam questions to improve the accuracy of their calculations.00 12.800m2 x £2. no under or over absorption of overhead occurs.800m2 x £2.200 Fav sales volume Standard usage at standard cost 1.300 units x 6m2 x £2.380 Price >£780 Adv £15.000 hours x £15. they get easier with practice.00 = Steve Jay is examiner for CAT Paper 7 £163.40 = Actual usage at standard cost 16.500 Expenditure >£500 Adv £75.00 24.600 Fav £24.000m x £1. As a result.10 = Actual hours at standard rate 5.technical EXAMPLE 2 £ per unit Selling price Direct material: Wood 12 metres @ £1.300 units x 4 hours x £15. As fixed overheads are not absorbed into production.400 £16.00 136.00 per metre2 Direct labour: 4 hours @ £6. ANSWERS Wood Actual usage at actual cost 16.000 Usage >£600 Adv £23.00 = The first change is that the calculation of the fixed overhead variances becomes much simpler.00 Contribution £ per unit 250.00 18. the sales volume variance is based on contribution per unit.300 units x 12m x £1. the fixed overhead volume variance (and its subdivision into capacity and efficiency) is no longer required.000 hours x £15.000m x £1.00 = Standard hours at standard rate 1. Lesson 9 In a marginal costing system. all that remains is the fixed overhead expenditure variance.00 = Variable overhead Actual hours at actual rate 5.000 units x £136 = Actual sales units @ standard contribution margin 1. and a further mark if correctly labelled as adverse or favourable. £75. Try marking your own attempts and work out how many extra marks you would have gained by avoiding the mistakes listed above. but as with most things.